SMChap 024

Chapter 24 - The U.S.
Taxation of Multinational Transactions
Chapter 24
The U.S. Taxation of Multinational Transactions
SOLUTIONS MANUAL
DISCUSSION QUESTIONS
1. (LO 1) Distinguish between an outbound transaction and an inbound transaction from a U.S.
tax perspective.
Answer:
An outbound transaction occurs when a U.S. person engages in a transaction outside
the United States or one that involves a non-U.S. person. An inbound transaction
occurs when a non-US. person engages in a transaction within the United States or one
that involves a U.S. person.
2. (LO 1) What are the major U.S. tax issues that apply to an inbound transaction?
Answer:
The major U.S. tax issues that apply to an inbound transaction involve 1) whether the
non-U.S. person has nexus in the United States (is subject to U.S. taxation), 2) whether
the income earned by the non-U.S. person is from U.S. sources, 3) the type of U.S.
source income earned (income effectively connected with a U.S. trade or business (ECI)
or income that is fixed, determinable, annual or periodic (FDAP), and 4) whether a
treaty applies to change the U.S. taxation of the transaction that otherwise would apply.
3. (LO 1) What are the major U.S. tax issues that apply to an outbound transaction?
Answer:
The major U.S. tax issues that apply to an outbound transaction involve 1) whether the
income earned by the U.S. person is from foreign sources, 2) whether the U.S. person
incurs a foreign income tax on the income that is eligible for a credit, 3) the type of
foreign source income earned (passive category or general category), and 4) what
deductions taken on the U.S. tax return must be allocated and apportioned to foreign
source income for foreign tax credit purposes.
4. (LO 1) How does a residence-based approach to taxing worldwide income differ from a
source-based approach to taxing the same income.
Answer:
Under a residence-based approach, a country taxes the worldwide income of the person
earning the income. Under a source-based approach, a country taxes only the income
earned within its boundaries.
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Chapter 24 - The U.S. Taxation of Multinational Transactions
5. (LO 1) Henri is a resident of the United States for U.S. tax purposes and earns $10,000 from
an investment in a French company. Will Henri be subject to U.S. tax under a residence-based
approach to taxation? A source-based approach?
Answer:
Henri will be subject to U.S. tax on the income under a residence-based approach.
Henri will not be subject to U.S. tax on the income under a source-based approach
because the income is not U.S. source income.
6. (LO 1) What are the two categories of income that can be taxed by the United States when
earned by a nonresident? How does the United States tax each category of income?
Answer:
U.S. source income earned by a nonresident is classified as either effectively connected
income (ECI) or fixed and determinable, annual or periodic income (FDAP). Income
that is effectively connected with a U.S. trade or business is subject to net taxation (that
is, gross income minus deductions) at the U.S. graduated tax rates. FDAP income,
which is generally passive income such as dividends, interest, rents, or royalties, is
subject to a withholding tax regime applied to gross income.
7. (LO 1) Maria is not a citizen of the United States, but she spends 180 days per year in the
United States on business-related activities. Under what conditions will Maria be considered a
resident of the United States for U.S. tax purposes?
Answer:
Maria will be considered a resident if she meets one of two tests. Maria will be treated
as a resident if she possesses a permanent resident visa (green card) at any time during
the calendar year. Maria also will be treated as a resident if she meets the substantial
presence test, which will be met if she is physically present in the United States for 31
days or more during the current calendar year, and the number of days of physical
presence during the current calendar year plus 1/3 times the number of days of physical
presence during the first preceding year plus 1/6 times the number of days of physical
presence during the second preceding year equals or exceeds 183. Maria does not meet
the substantial presence test if she has not been physically present in the United States
during the previous two years. She would, however, be considered a resident if she was
in the United States during the current year for at least 183 days.
8. (LO 1) Natasha is not a citizen of the United States, but she spends 200 days per year in the
United States on business. She does not have a green card. True or False. Natasha will always
be considered a resident of the United States for U.S. tax purposes because of her physical
presence in the United States. Explain.
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Answer:
False. Natasha will likely be treated as a resident because she meets the physical
presence test of the substantial presence test.. She could qualify for nonresident
status if she meets an exception in the Internal Revenue Code (for example, she is a
student) or she qualifies for nonresident status under a treaty between the United States
and her country of residence.
9. (LO 1) Why does the United States allow U.S. taxpayers to claim a credit against their
precredit U.S. tax for foreign income taxes paid?
Answer:
The United States applies a residual approach to taxing foreign source income earned
by U.S. persons. Under this approach, the U.S. government collects the difference
between the U.S. tax that would have been paid if the income had been U.S. source and
the foreign tax paid on such income. The U.S. accomplishes this objective by allowing
the U.S. person a credit for the foreign taxes paid.
10. (LO 1) What role does the foreign tax credit limitation play in U.S. tax policy?
Answer:
The foreign tax credit limitation is designed to limit the credit allowed for foreign
income taxes paid to the amount of U.S. income tax that would have been paid on the
income if it was earned in the U.S.
11. (LO 2) Why are the income source rules important to a U.S. citizen or resident?
Answer:
The income source rules can be important to a U.S. citizen or resident for several
reasons: 1) To calculate the numerator in the foreign tax credit limitation calculation
(foreign source taxable income), 2) a U.S. citizen or resident employed outside the
United States may be eligible to exclude a portion of foreign source earned income from
U.S. taxation under 911, and 3) a U.S. citizen or resident who pays U.S.-source FDAP
income to a foreign person (for example, interest or dividends) may be required to
withhold U.S. taxes on such payments.
12. (LO 2) Why are the income source rules important to a U.S. nonresident?
Answer:
The U.S. source-of-income rules are important to a U.S. nonresident because they limit
the scope of U.S. taxation to only the nonresidents U.S. source income.
13. (LO 2) Carol receives $500 of dividend income from Microsoft, Inc., a U.S. company. True
or False. Absent any treaty provisions, Carol will be subject to U.S. tax on the dividend
regardless of whether she is a resident or nonresident. Explain.
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Answer:
True. Carol will be taxed on all of her income if she is a resident. As a nonresident, she
will be taxed only on her U.S. source income. Because Microsoft is a U.S. company, the
dividend will be treated as U.S. source income and will be subject to (withholding) tax.
14. (LO 2) Pavel, a citizen and resident of Russia, spent 100 days in the United States working
for his employer, Yukos Oil, a Russian corporation. Under what conditions will Pavel be
subject to U.S. tax on the portion of his compensation earned while working in the United
States?
Answer:
As a nonresident, Pavel will be subject to U.S. tax on the portion of his compensation
that is treated as U.S. source income, which is usually determined based on how much
time he spends working in the United States. Pavel may be exempt from U.S. tax on the
compensation under a treaty provision in the U.S. Russia income tax treaty.
15. (LO 2) What are the potential U.S. tax benefits from engaging in a 863(b) sale?
Answer:
In a 863 (mixed source) sale, a U.S. person may be able to treat a portion of the gross
profit from the sale of inventory manufactured in the United States and sold outside the
United States as foreign source. The portion treated as foreign source will be added to
the numerator of the foreign tax credit limitation, potentially absorbing any excess
foreign tax credits from other transactions.
16. (LO 2) True or False. A taxpayer will always prefer deducting an expense against U.S.
source income and not foreign source income when filing a tax return in the United States.
Explain.
Answer:
True. The deduction reduces taxable income in either case. By apportioning the
expense to U.S. source income, the taxpayer maximizes the numerator of the foreign tax
credit limitation and, by so doing, maximizes the foreign tax credit.
17. (LO 2) Distinguish between allocation and apportionment in sourcing deductions in
computing the foreign tax credit limitation.
Answer:
Allocation is the qualitative process of associating a deduction with a specific item or
items of gross income for purposes of computing foreign source taxable income.
Apportionment is the quantitative process of calculating the amount of a deduction that
is associated with a specific item or items of gross income for purposes of computing
foreign source taxable income.
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18. (LO 2) Distinguish between a definitely related deduction and a not definitely related
deduction in the allocation and apportionment of deductions to foreign source taxable income.
Answer:
A definitely related deduction is a deduction that can be directly associated with a
particular item of income (for example, machine depreciation with manufacturing gross
profit). A deduction not directly associated with a particular item of gross income (for
example, medical expenses) is referred to as a not definitely related deduction.
19. (LO 2) Briefly describe the two different methods for apportioning interest expense to
foreign source taxable income in the computation of the foreign tax credit limitation.
Answer:
Interest expense is allocated to all gross income based on the assets that generated such
income. Interest can be apportioned based on average tax book value or average fair
market value for the year.
20. (LO 2) Briefly describe the two different methods for apportioning R&E to foreign source
taxable income in the computation of the foreign tax credit limitation.
Answer:
R&E expenditures can be apportioned between U.S. and foreign source income using
either a sales method or a gross income method.
21. (LO 2) IBM incurs $250 million of R&E in the United States. How does the exclusive
apportionment of this deduction differ depending on the R&E apportionment method chosen in
the computation of the foreign tax credit limitation?
Answer:
IBM can exclusively apportion a percentage of R&E based on where the research is
conducted. The amount that can be sourced under this exclusive apportionment option
is 50 percent if the sales method is elected and 25 percent if the gross income method is
elected. In this case, IBM can exclusively source $125 million as being U.S. source if it
chooses to apportion the remaining R&E using the sales method. IBM can source $62.5
million as being U.S. source if it chooses to apportion the remaining R&E using the
gross income method.
22. (LO 3) What is the primary goal of the United States in negotiating income tax treaties with
other countries?
Answer:
The U.S. government negotiates treaties to promote trade between the United States and
a treaty partner. An income tax treaty is a bilateral agreement between the United
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States and another country in which each country agrees to modify its own tax laws to
achieve reciprocal benefits. The general purpose of an income tax treaty is to eliminate
or reduce the impact of double taxation on cross-border transactions so that residents
paying taxes to one country will not have the full burden of taxes in the other country.
23. (LO 3) What is a permanent establishment and why is it an important part of most income
tax treaties?
Answer:
A permanent establishment generally is a fixed place of business such as an office or
factory, although employees acting as agents can create a permanent establishment.
U.S. (non-U.S.) businesses generally are not taxed on business profits earned in the host
treaty country (United States) unless they conduct their business in that country through
a permanent establishment.
24. (LO 3) Why is a treaty important to a nonresident investor in U.S. stocks and bonds?
Answer:
A treaty often reduces (or eliminates) the U.S. statutory withholding tax (30 percent)
otherwise imposed on U.S. source interest and dividends paid to a nonresident investor.
25. (LO 3) Why is a treaty important to a nonresident worker in the United States?
Answer:
A nonresident worker in the United States generally will be subject to U.S. tax on his or
her U.S. source wages. A treaty may exempt such wages from U.S. tax if the worker is in
the United States for less than a prescribed number of days or the total wages do not
exceed a stated amount.
26. (LO 4) Why does the United States use a basket approach in the foreign tax credit
limitation computation?
Answer:
The basket approach limits foreign tax credit blending opportunities (high-tax foreign
source income and low-tax foreign source income) to income that is of the same
character. Currently, there are two primary categories of FTC income, passive category
income and general category income.
27. (LO 4) True or False. All dividend income received by a U.S. taxpayer is classified as
passive category income for foreign tax credit limitation purposes. Explain.
Answer:
False. Dividends received from a joint venture (10/50 company) or a controlled
foreign corporation are subject to look-through rules. Under these rules, the
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dividend recipient characterizes the dividend for FTC basket purposes based on the
source(s) of income from which the dividend is paid.
28. (LO 4) True or False. All foreign taxes are creditable for U.S. tax purposes. Explain.
Answer:
False. Only foreign income taxes are creditable for U.S. tax purposes. Other foreign
taxes can be deducted in computing taxable income.
29. (LO 4) What is an indirect credit for foreign tax credit purposes? What is the tax policy
reason for allowing such a credit?
Answer:
Indirect taxes are foreign income taxes imposed on the income of a U.S.-owned foreign
subsidiary or foreign joint venture and which are creditable by certain U.S. corporate
shareholders when they receive a dividend from the subsidiary or joint venture. To put
the U.S. tax consequences of a dividend distribution on equal footing with branch
income, the United States allows eligible U.S. corporations to impute a foreign tax
credit for the income taxes paid by the foreign subsidiary on the dividend received. The
dividend is grossed-up by the amount of the credit so that pretax income of the
foreign corporation or joint venture is reported in the U.S. shareholders taxable
income, as would be the case with branch income.
30. (LO 4) What is a functional currency? What role does it play in the computation of an
indirect credit for foreign tax credit purposes?
Answer:
Functional currency is the currency of the primary economic environment in which an
entity operates (that is, the currency of the jurisdiction in which an entity primarily
generates and expends cash). A foreign joint venture or controlled foreign corporation
must maintain its post-1986 earnings and profits for indirect foreign tax credit purposes
using its functional currency unless the corporation keeps its books in U.S. dollars.
31. (LO 5) What is a hybrid entity for U.S. tax purposes? Why is a hybrid entity a popular
organizational form for a U.S. company expanding its international operations? What are the
potential drawbacks to using a hybrid entity?
Answer:
A hybrid entity is an entity for which an election is available to choose the entitys tax
status for U.S. tax purposes. Hybrid entities such as limited liability companies can
provide the U.S. investor with the legal advantages of corporate form (limited liability,
continuity of life, transferability of interests) and the tax advantages of partnership or
branch form (flow-through of losses and flow-through of foreign taxes to investors). A
potential drawback to operating through a hybrid entity in a foreign jurisdiction is the
entity may not be eligible for treaty benefits because the host country does not recognize
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it as a resident of the host country, which is a prerequisite to being eligible for treaty
benefits (an example would be the U.S. Canada income tax treaty).
32. (LO 5) What is a per se entity under the check-the-box rules?
Answer:
A per se entity is a foreign entity that is not eligible to make a check-the-box election
to be treated as a flow-through entity for U.S. tax purposes. These ineligible entities
tend to be entities that can be publicly traded in their host countries (for example, a
German A.G., Dutch N.V., U.K. PLC, Spanish S.A., and a Canadian Corporation).
33. (LO 6) What are the requirements for a foreign corporation to be a controlled foreign
corporation for U.S. tax purposes?
Answer:
A controlled foreign corporation is defined as any foreign corporation in which U.S.
shareholders collectively own more than 50 percent of the total combined voting power
of all classes of stock entitled to vote or the total value of the corporations stock on any
day during the foreign corporations tax year. For this purpose, a U.S. shareholder is
any U.S. person who owns or is deemed to own 10 percent or more of all classes of stock
entitled to vote.
34. (LO 6) Why does the United States not allow deferral on all foreign source income earned
by a controlled foreign corporation?
Answer:
Deferral of U.S. taxation on all foreign source income earned through a foreign
subsidiary would invite tax planning strategies that shift income to low-tax countries to
minimize the taxpayers worldwide tax liability. U.S. taxpayers could transfer
investment assets to corporations located in low (no) tax countries (tax havens) and
defer U.S. tax on such low-tax or tax-exempt income until it was repatriated to the
United States.
35. (LO 6) True or False. A foreign corporation owned equally by 11 U.S. individuals can
never be a controlled foreign corporation? Explain.
Answer:
False. Although each shareholder owns less than 10 percent of the foreign
corporations stock directly, and thus does not qualify as a U.S. shareholder for CFC
purposes, one or more of the shareholders could be deemed to own stock of another
shareholder through the stock attribution (constructive ownership) rules. For example,
one or more of the shareholders could be members of the same family (parents, children,
grandchildren). The constructive ownership rules could cause one or more
shareholders to be U.S. shareholders whose collective ownership of stock could exceed
50 percent.
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36. (LO 6) What is foreign base company sales income? Why does the United States include
this income in its definition of subpart F income?
Answer:
Foreign base company sales income is defined as income derived by a CFC from the
sale or purchase of personal property (for example, inventory) to (or from) a related
person and the property is manufactured and sold outside the CFCs country of
incorporation. This category of subpart F income was added because many countries
offer incentives to multinational corporations to locate holding companies or sales
companies within their borders by imposing no or a low tax on investment income or
export sales. Without any anti-deferral rules, a U.S. multinational corporation could
shift profits to a foreign base company by selling goods to the base company at an
artificially low transfer price. The base company could then resell the goods at a higher
price to the ultimate customer in a different country. The profit earned by the base
company would be subject to the lower (or no) tax imposed by the tax haven country.
37. (LO 6) True or False. Subpart F income is always treated as a deemed dividend to the U.S.
shareholders of a controlled foreign corporation. Explain.
Answer:
False. Subpart F income is not treated as a deemed dividend if the total amount falls
below a prescribed de minimis amount, which is the lesser of 5 percent of gross income
or $1 million. In addition, a U.S. shareholder can elect to exclude high tax subpart F
income from the deemed dividend rules. High-tax subpart F income is income taxed at
an effective tax rate that is 90 percent or more of the highest U.S. statutory rate. For a
U.S. corporation, the high tax rate currently is 31.5 percent.
38. (LO 6) True or False. Non-subpart F income always qualifies for tax deferral until it is
repatriated back to the United States. Explain.
Answer:
False. Non-subpart F income that is invested in U.S. property (for example, a loan from
the CFC to its U.S. shareholder) could be treated as a deemed dividend under the
subpart F rules.
PROBLEMS
39. (LO 1) Camille, a citizen and resident of Country A, received a $1,000 dividend from a
corporation organized in Country B. Which statement best describes the taxation of this income
under the two different approaches to taxing foreign income?
a. Country B will not tax this income under a residence-based jurisdiction approach but
will tax this income under a source-based jurisdiction approach.
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b. Country B will tax this income under a residence-based jurisdiction approach but will
not tax this income under a source-based jurisdiction approach.
c. Country B will tax this income under both a residence-based jurisdiction approach and
a source-based jurisdiction approach.
d. Country B will not tax this income under either a residence-based jurisdiction
approach or a source-based jurisdiction approach.
Answer:
a. Country B will not tax this income under a residence-based jurisdiction approach but
will tax this income under a source-based jurisdiction approach.
40. (LO 1) Spartan Corporation, a U.S. corporation, reported $2 million of pretax income from
its business operations in Spartania, which were conducted through a foreign branch. Spartania
taxes branch income at 25%, and the United States taxes corporate income at 35%.
a. If the United States provided no mechanism for mitigating double taxation, what
would be the total tax (U.S. and foreign) on the $2 million of branch profits?
Answer:
Spartania tax ($2,000,000 25%)
U.S. tax ($2,000,000 35%)
Total tax
$ 500,000
700,000
$1,200,000
b. Assume the United States allows U.S. corporations to exclude foreign source income
from U.S. taxation. What would be the total tax on the $2 million of branch profits?
Answer:
U.S. tax ($0 35%)
Total tax
$500,000
0
$500,000
c. Assume the United States allows U.S. corporations to claim a deduction for foreign
income taxes. What would be the total tax on the $2 million of branch profits?
Answer:
U.S. tax ([$2,000,000 500,000] 35%)
Total tax
$ 500,000
525,000
$1,025,000
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d. Assume the United States allows U.S. corporations to claim a credit for foreign
income taxes paid on foreign source income. What would be the total tax on the $2
million of branch profits? What would be your answer if Spartania taxed branch profits
at 40%?
Answer:
U.S. tax ([$2,000,000 35%] - $500,000]
Total tax
$ 500,000
200,000
$700,000
If Spartania taxed branch profits at 40 percent, the United States would subsidize the
Spartania government by giving the U.S. taxpayer a refund for the excess taxes paid to
Spartania.
U.S. tax ([$2,000,000 35%] - $800,000]
Total tax
$800,000
(100,000)
$700,000
41. (LO 1) Guido is a citizen and resident of Belgium. He has a full-time job in Belgium and
has lived there with his family for the past 10 years. In 2011, Guido came to the United States
for the first time. The sole purpose of his trip was business. He intended to stay in the United
States for only 180 days, but he ended up staying for 210 days because of unforeseen problems
with his business. Guido came to the United States again on business in 2012 and stayed for
180 days. In 2013 he came back to the United States on business and stayed for 70 days.
Determine if Guido meets the U.S. statutory definition of a resident alien in 2011, 2012, and
2013 under the substantial presence test.
Answer:
2011: Guido meets the definition of a resident alien under the substantial presence test
because he is physically present in the United States for at least 183 days. He cannot
use the closer connection exception because he is physically present in the United
States for 183 days or more.
2012: Guido meets the definition of a resident alien under the substantial presence test.
His days of physical presence for 2012 total 250, computed as 180 (2012) + {1/3 210
(2011) = 70}. Because Guido is physically present in the United States for less than 183
days in 2012, he can argue that he has a closer connection to Belgium than to the
United States to be exempt from the physical presence test. Guido must show that his
tax home (regular place of business) is in Belgium.
2013: Guido does not meet the definition of a resident alien under the substantial
presence test. His days of physical presence for 2013 total 165, computed as 70 (2012)
+ {1/3 180 (2011) = 60} + {1/6 210 (2010) = 35}.
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42. (LO 1) {research} Use the facts in problem 41. If Guido meets the statutory requirements
to be considered a resident of both the United States and Belgium, what criteria does the U.S.Belgium treaty use to break the tie and determine Guidos country of residence? Look at
Article 4 of the 2006 U.S.-Belgium income tax treaty, which you can find on the IRS website,
www.irs.gov.
Answer:
When an individual is claimed as a resident by two jurisdictions, the individual must
consult the tie breaker rules under the U.S.-Belgium income tax treaty. Article 4 of
the U.S. Belgium treaty (Resident), 4, states that where an individual is a resident
of both Contracting States, he must look to where he has (in descending order):
1.
2.
3.
4.
Permanent home (the place where an individual dwells with his family)
Center of vital interests (where his personal and economic relations are closer)
Habitual abode
Citizenship (national)
If none of the above criteria is determinative of an individuals residence, the issue will
be resolved by mutual agreement of the competent authorities of both countries. Because
Guido has his permanent home in Belgium, he would be treated as a resident of Belgium
for U.S. tax purposes.
43. (LO 1) {research} How does the U.S.-Belgium treaty define a permanent establishment for
determining nexus? Look at Article 5 of the 2006 U.S.-Belgium income tax treaty, which you
can find on the IRS Website, www.irs.gov.
Answer:
Article 5 defines a permanent establishment as a fixed place of business through which
the business of an enterprise is wholly or partly carried on. In particular, a permanent
establishment includes a place of management, a branch, an office, a factory, a
workshop, and a mine, an oil or gas well, a quarry, or any other place of extraction of
natural resources. Article 5 excludes the following activities as creating a permanent
establishment: a) the use of facilities solely for the purpose of storage, display or
delivery of goods or merchandise belonging to the enterprise; b) the maintenance of a
stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery; c) the maintenance of a stock of goods or merchandise
belonging to the enterprise solely for the purpose of processing by another enterprise;
d) the maintenance of a fixed place of business solely for the purpose of purchasing
goods or merchandise, or of collecting information, for the enterprise; e) the
maintenance of a fixed place of business solely for the purpose of carrying on, for the
enterprise, any other activity of a preparatory or auxiliary character; and f) the
maintenance of a fixed place of business solely for any combination of the activities
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mentioned in subparagraphs a) through e), provided that the overall activity of the fixed
place of business resulting from this combination is of a preparatory or auxiliary
character.
44. (LO 1) Mackinac Corporation, a U.S. corporation, reported total taxable income of $5
million. Taxable income included $1.5 million of foreign source taxable income from the
companys branch operations in Canada. All of the branch income is general category income.
Mackinac paid Canadian income taxes of $600,000 on its branch income. Compute Mackinacs
allowable foreign tax credit. Assume a U.S. corporate tax rate of 34%.
Answer:
Mackinac Corporations precredit U.S. tax is $1,700,000 ($5,000,000 x 34%). The
companys foreign tax credit limitation is computed as:
$1,500,000 / $5,000,000 x $1,700,000 = $510,000.
Mackinacs allowable foreign tax credit is limited to $510,000, creating an excess
credit of $90,000 ($600,000 - $510,000), which can be carried back one year and
carried forward 10 years.
45. (LO 1) Waco Leather, Inc., a U.S. corporation, reported total taxable income of $5 million.
Taxable income included 1.5 million of foreign source taxable income from the companys
branch operations in Mexico. All of the branch income is general category income. Waco paid
Mexican income taxes of $420,000 on its branch income. Compute Wacos allowable foreign
tax credit. Assume a U.S. corporate tax rate of 34%.
Answer:
Wacos precredit U.S. tax is $1,700,000 ($5,000,000 x 34%). The companys foreign tax
credit limitation is computed as:
$1,500,000 / $5,000,000 x $1,700,000 = $510,000.
Wacos allowable foreign tax credit is the full $420,000. Waco has an excess
limitation of $90,000, which could absorb foreign tax credit carryforwards from prior
years.
46. (LO 2) Petoskey Stone, Inc., a U.S. corporation, received the following sources of income
during the current year. Identify the source of each item as either U.S. or foreign.
Answer:
a. Interest income from a loan to its German subsidiary: Foreign source (residence of
the payer of interest)
b. Dividend income from Granite Corporation, a U.S. corporation: U.S. source
(residence of the payer of the dividend)
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c. Royalty income from its Irish subsidiary for use of a trademark: Foreign source
(where the intangible is used)
d. Rent income from its Canadian subsidiary of a warehouse located in Wisconsin: U.S.
source (where the property being rented is located)
47. (LO 2) Carmen SanDiego, a U.S. citizen, is employed by General Motors Corporation, a
U.S. corporation. On April 1, 2013, GM relocated Carmen to its Brazilian operations for the
remainder of 2013. Carmen was paid a salary of $120,000 and was employed on a 5-day week
basis. As part of her compensation package for moving to Brazil, Carmen also received a
housing allowance of $25,000. Carmens salary was earned ratably over the twelve month
period. During 2013 Carmen worked 260 days, 195 of which were in Brazil and 65 of which
were in Michigan. How much of Carmens total compensation is treated as foreign source
income for 2013? Why might Carmen want to maximize her foreign source income in 2013?
Answer:
Carmen classifies her wages as being U.S. or foreign source based on her working days
within the United States and Brazil. Her foreign source wages will be $90,000, calculated
as 195 / 260 x $120,000. The $25,000 housing allowance will be treated as foreign source
because it is paid to her while she is working in Brazil. Her total foreign source
compensation is $115,000 ($90,000 + $125,000). Carmen has an incentive to maximize
her foreign source compensation if (when) she becomes eligible for the foreign earned
income exclusion under 911, which is $97,600 in 2013 (pro-rated for the number of days
she is physically present in Brazil).
48. (LO 2) John Elton is a citizen and bona fide resident of Great Britain (United Kingdom).
During the current year, John received the following income:
o Compensation of $30 million from performing concerts in the United States
o Cash dividends of $10,000 from a French corporation stock
o Interest of $6,000 on a U.S. corporation bond
o Interest of $2,000 on a loan made to a U.S. citizen residing in Australia
o Gain of $80,000 on the sale of stock in a U.S. corporation
24-14
Determine the source (U.S. or foreign) of each item of income John received.
Answer:
Income
Source
Income from concerts
U.S. source based on where the event took place
Dividend from French corporation
Foreign source based on residence of the payer
Interest on a U.S. corporation bond
U.S. source based on residence of the payer
Interest of $2,000 on a loan made to a

U.S. citizen residing in Australia
Foreign source based on residence of the payer
Gain of $80,000 on the sale of stock

in a U.S. corporation
Foreign source based on residence of the seller
49. (LO 2) Spartan Corporation, a U.S. company, manufactures green eye shades for sale in the
United States and Europe. All manufacturing activities take place in Michigan. During the
current year, Spartan sold 10,000 green eye shades to European customers at a price of $10
each. Each eye shade costs $4 to produce. All of Spartans production assets are located in the
United States. For each independent scenario, determine the source of the gross income from
sale of the green eye shades.
a. Spartan ships its eye shades F.O.B., place of destination.
Answer:
Gross profit from the sales is $60,000 (10,000 units {$10 - $4}). Under the 863(b)
formula method, 50 percent of gross profit is sourced based on the location of the
production assets, and 50 percent is sourced based on where title to the inventory sold
passes.
Apportioned to production activity ($30,000) U.S. source. All of the production assets
are located in the United States. Therefore, the gross profit related to production
activity is classified as U.S. source income.
Apportioned to sales activity ($30,000) Foreign source. Because title passes outside
the United States, the portion of gross profit related to sales activity is classified as
foreign source income.
24-15
b. Spartan ships its eye shades F.O.B., place of shipment.

Answer:
Apportioned to production activity ($30,000) U.S. source. All of the production assets
are located in the United States. Therefore, the gross profit related to production
activity is classified as U.S. source income.
Apportioned to sales activity ($30,000) U.S. source. Because title passes within the
United States, the portion of gross profit related to sales activity is classified as U.S.
source income.
50. (LO 2) {Planning} Falmouth Kettle Company, a U.S. corporation, sells its products in the
United States and Europe. During the current year, selling, general, and administrative (SG&A)
expenses included:
Personnel department
Training department
Presidents salary
Sales managers salary
Other general and administrative
Total SG&A expenses
$500
350
400
200
550
$2,000
Falmouth had $12,000 of gross sales to U.S. customers and $3,000 of gross sales to European
customers. Gross profit (sales minus cost of goods sold) from domestic sales was $3,000 and
gross profit from foreign sales was $1,000. Apportion Falmouths SG&A expenses to foreign
source income using the following methods:
a. Gross sales
Answer:
To foreign source income: $3,000/$15,000 $2,000 = $400
To U.S. source income: $12,000/$15,000 $2,000 = $1,600
b. Gross income
Answer:
To foreign source income: $1,000/$4,000 $2,000 = $500
To U.S. source income: $3,000/$4,000 $2,000 = $1,500
c. If Falmouth wants to maximize its foreign tax credit limitation, which method
produces the better outcome?
24-16
Answer:
The gross sales method apportions the smaller amount of deductions to the numerator of
Falmouths foreign tax credit limitation formula. As a result, the foreign tax credit
limitation ratio will be higher under the gross sales method and the companys foreign
tax credit will be higher.
51. (LO 2) {Planning} Owl Vision Corporation (OVC) is a North Carolina corporation engaged
in the manufacture and sale of contact lens and other optical equipment. The company handles
its export sales through sales branches in Belgium and Singapore. The average tax book value
of OVCs assets for the year was $200 million, of which $160 million generated U.S. source
income and $40 million generated foreign source income. The average fair market value of
OVCs assets was $240 million, of which $180 million generated U.S. source income and $60
million generated foreign source income. OVCs total interest expense was $20 million.
a. What amount of the interest expense will be apportioned to foreign source income
under the tax book value method?
Answer:
Apportionment using tax book value
Tax book value of U.S. assets = $160,000
Tax book value of foreign assets = $40,000
Interest apportioned to U.S. source income: $160,000,000/$200,000,000 $20,000 =
$16,000
Interest apportioned to foreign source income: $40,000,000/$200,000,000 $20,000 =
$4,000
b. What amount of the interest expense will be apportioned to foreign source income
under the fair market value method?
Answer:
Apportionment using fair market value
Fair market value of U.S. assets = $180,000
Fair market value of foreign assets = $60,000
Interest apportioned to U.S. source income: $180,000,000/$240,000,000 $20,000 =
$15,000
Interest apportioned to foreign source income: $60,000,000/$240,000,000 $20,000 =
$5,000
c. If Owl wants to maximize its foreign tax credit limitation, which method produces the
24-17
better outcome?
24-18
Answer:
Based on the facts, the tax book value method apportions the smaller amount of interest
to the numerator of the foreign tax credit limitation ratio. As a result, the foreign tax
credit limitation ratio will be higher under the tax book value method and the companys
foreign tax credit will be higher.
52. (LO 2) {Planning} Freon Corporation, a U.S. corporation, manufactures air-conditioning
and warm air heating equipment. Freon reported gross sales from this product group of
$50,000,000, of which $10,000,000 were foreign source. The gross profit percentage for
domestic sales was 15%, and the gross profit percentage from non-U.S. sales was 20%. Freon
incurred R&E expenses of $6,000,000, all of which were conducted in the United States.
a. What amount of the R&E expense will be apportioned to foreign source income under
the sales method?
Answer:
Apportionment using the sales method
Total R&E
Exclusive apportionment to U.S. gross income
50% $6,000,000
Non-exclusively apportioned R&E
$6,000,000
(3,000,000)
$3,000,000
Apportionment by gross sales

To U.S. source: $40,000,000/$50,000,000 $3,000,000
$2,400,000
To foreign source: $10,000,000/$50,000,000 $3,000,000
600,000
Total U.S. source R&E ($2,400,000 + $3,000,000)
Total foreign source R&E
$5,400,000
$ 600,000
b. What amount of the R&E expense will be apportioned to foreign source income under
the gross income method?
Answer:
Apportionment using the gross income method
Total R&E
Exclusive apportionment to U.S. gross income
25% $6,000,000
Non-exclusively apportioned R&E
U.S. source gross income (15% x $40,000,000)
Foreign source gross income (20% x $10,000,000)
$6,000,000
(1,500,000)
$4,500,000
$6,000,000
$2,000,000
24-19
Apportionment by gross income

To U.S. source: $6,000,000/$8,000,000 $4,500,000
To foreign source: $2,000,000/$8,000,000 $4,500,000
$3,375,000
$1,125,000
Total U.S. source R&E ($1,500,000 + $3,375,000)

Total foreign source R&E
$4,875,000
$1,125,000
c. If Freon wants to maximize its foreign tax credit limitation, which method produces
the better outcome?
Answer:
The gross income method apportions the smaller amount of R&E to the numerator of
Freons foreign tax credit limitation formula. As a result, the foreign tax credit
limitation ratio will be higher under the gross sales method and the companys foreign
tax credit will be higher.
53. (LO 3) {research} Colleen is a citizen and bona fide resident of Ireland. During the current
year, she received the following income:
o Cash dividends of $2,000 from a U.S. corporation stock
o Interest of $1,000 on a U.S. corporation bond
o Royalty of $100,000 from a U.S. corporation for use of a patent she developed
o Rent of $3,000 from U.S. individuals renting her cottage in Maine
Identify the U.S. withholding tax rate on the payment of each item of income under the U.S.Ireland income tax treaty and cite the appropriate treaty article. You can access the 1997 U.S.Ireland income tax treaty on the IRS website, www.irs.gov.
Answer:
Income
Withholding Tax Rate
Treaty Article
15%
Article 10, 2(b)
0%
Article 11, 1
0%
Article 12, 1
30% (U.S. statutory

rate)
Article 6, 1
Cash dividends of $2,000

Interest of $1,000
Royalty of $100,000
Rent of $3,000
24-20
54. (LO 4) Gameco, a U.S. corporation, operates gambling machines in the United States and
abroad. Gameco conducts its operations in Europe through a Dutch B.V., which is treated as a
branch for U.S. tax purposes. Gameco also licenses game machines to an unrelated company in
Japan. During the current year, Gameco paid the following foreign taxes, translated into U.S.
dollars at the appropriate exchange rate:
Foreign Taxes
National income taxes
City (Amsterdam) income taxes
Value-added tax
Payroll tax (employers share of social insurance contributions)
Withholding tax on royalties received from Japan
Amount (in $)
1,000,000
100,000
150,000
400,000
50,000
Identify Gamecos creditable foreign taxes.

Answer:
Gamecos creditable foreign taxes are those taxes that qualify as income taxes or taxes
paid in lieu of income taxes. The creditable income taxes are the national income taxes
and the city of Amsterdam income taxes. The withholding tax is creditable because it is
imposed in lieu of an income tax.
55. (LO 4) {Planning} Sombrero Corporation, a U.S. corporation, operates through a branch in
Espania. Management projects that the companys pretax income in the next taxable year will
be $100,000, $80,000 from U.S. operations and $20,000 from the branch. Espania taxes
corporate income at a rate of 45%. The U.S. corporate tax rate is 35%.
a. If managements projections are accurate, what will be Sombreros excess foreign tax
credit in the next taxable year? Assume all of the income is general category income.
Answer:
Taxable income
x 35%
Precredit U.S. tax
$100,000
x
0.35
$ 35,000
Foreign tax ($20,000 x 45%)

FTC limitation:
$20,000 / $100,000 x $35,000
Excess FTC
$9,000
7,000
$2,000
b. Management plans to establish a second branch in Italia. Italia taxes corporate

income at a rate of 30%. What amount of income will the branch in Italia have to
generate to eliminate the excess credit generated by the branch in Espania?
24-21
Answer:
Each dollar of foreign taxable income earned in Italia generates an excess FTC
limitation of $0.05 [$1 (35% - 30%)]. Sombrero must generate enough low-tax
general category foreign source taxable income to eliminate the $2,000 excess credit.
The excess credit will be eliminated if Sombrero can generate $40,000 of income in
Italia ($2,000/.05).
Foreign income taxes
Espania ($20,000 45%)
Italia ($40,000 30%)
Total
$ 9,000
12,000
$21,000
FTC Limitation:
Foreign source taxable income
Total taxable income ($100,000 + $40,000)
Precredit U.S. tax (35% $140,000)
FTC Limitation: $60,000/$140,000 $49,000
Excess foreign tax credit ($21,000 - $21,000)
$60,000
140,000
$49,000
$21,000
$0
56. (LO 4) Chapeau Company, a U.S. corporation, operates through a branch in Champagnia.
The source rules used by Champagnia are identical to those used by the United States. For
2013, Chapeau has $2,000 of gross income, $1,200 from U.S. sources and $800 from sources
within Champagnia. The $1,200 of U.S. source income and $700 of the foreign source income
are attributable to manufacturing activities in Champagnia (general category income). The
remaining $100 of foreign source income is passive category interest income. Chapeau had
$500 of expenses other than taxes, all of which are allocated directly to manufacturing income
($200 of which is apportioned to foreign sources). Chapeau paid $150 of income taxes to
Champagnia on its manufacturing income. The interest income was subject to a 10 percent
withholding tax of $10. Assume the U.S. tax rate is 35%. Compute Chapeaus allowable
foreign tax credit in 2013.
Answer:
Precredit U.S. tax
Total taxable income ($2,000 - $500)
Precredit U.S. tax ($1,500 35%)
$1,500
525
FTC limitation calculations

General category basket income (manufacturing)
Foreign source taxable income ($700 - $200)
FTC limitation: $500/$1,500 $525
Foreign tax imposed
$500
175
$150
24-22
Passive category basket income

Foreign source taxable income ($100 - $0)
FTC limitation: $100/$1,500 $525
Foreign tax imposed (withholding tax)
$100
35
$10
Foreign tax credit allowed

General category: Lesser of $175 or $150
Passive category: Lesser of $35 or $10
Total foreign tax credit
$150
10
$160
Excess foreign tax credit
$0
57. (LO 4) Paton Corporation, a U.S. corporation, owns 100% of the stock of Tappan Ltd, a
British corporation, and 100% of the stock of Monroe N.V., a Dutch corporation. Monroe has
post-1986 undistributed earnings of 600 and post-1986 foreign income taxes of $400. Tappan
has post-1986 undistributed earnings of 800 and post-1986 foreign income taxes of $200.
During the current year, Tappan paid Paton a dividend of 100 and Monroe paid Paton a
dividend of 100. The dividends were exempt from withholding tax under the U.S.-UK and
U.S.-Netherlands income tax treaties. The exchange rates are as follows: 1:$1.50 and
1:$2.00.
a. Compute Patons deemed paid credit on the dividends it received from Tappan and
Monroe.
Answer:
To be eligible for a deemed paid credit on the dividend from Tappan and Monroe, Paton
must own 10 percent-or-more of each corporations voting stock directly (which it does).
Monroes E&P and foreign taxes are as follows:
Undistributed
Earnings ()
Foreign
Taxes ($)
600
400
Monroes 100 dividend to Paton attracts a deemed paid credit of $67, computed as
follows: 100/600 $400. The 100 dividend translates into $150 using an exchange rate
of 1:$1.50.
24-23
Tappans E&P and foreign taxes are as follows:

Undistributed
Earnings ()
Foreign
Taxes ($)
800
200
Tappans 100 dividend to Paton attracts a deemed paid credit of $25, computed as follows:
100/800 $200 = $25
The 100 dividend translates to $200 using an exchange rate of 1:$2.00.
b. Assume this is Patons only income and compute the companys net U.S. tax after
allowance of any foreign tax credits.
Answer:
Patons U.S. tax liability is computed as follows:
Dividends ($150 + $200)
78 gross-up ($67 + $25)
Total income
U.S. tax rate
Pre-credit U.S. tax
902 credit
Net U.S. tax
$350.00
92.00
$442.00
0.35
$155.00
92.00
$ 63.00
58. (LO 4) {Planning} Hannah Corporation, a U.S. corporation, owns 100% of the stock its two
foreign corporations, Red S.A. and Cedar A.G. Red and Cedar derive all of their income from
active foreign business operations. Red operates in a low tax jurisdiction (20% tax rate), and
Cedar operates in a high tax jurisdiction (50% tax rate). Red has post-1986 foreign income
taxes of $200 and post-1986 undistributed earnings of 800u. Cedar has post-1986 foreign
income taxes of $500 and post-1986 undistributed earnings of 500q. No withholding taxes are
imposed on any dividends that Hannah receives from Red or Cedar. The exchange rate between
all three currencies is 1:1. Assume a U.S. corporate tax rate of 35%. Under the look-through
rules, all dividend income is treated as general category income.
a. Compute the effect of an 80u dividend from Red on Hannahs net U.S. tax liability.
Answer:
Hannahs deemed paid credit on the 80u dividend from Red is computed as follows:
80u/800u $200 = $20.
24-24
The 80u dividend translates to $80 using an exchange rate of $1:1u. Hannahs U.S. tax
liability is computed as follows:
Dividend
78 gross-up
Taxable income
U.S. tax rate
Precredit U.S. tax
902 credit
Net U.S. tax
$80.00
20.00
$100.00
0.35
$35.00
20.00
$15.00
Excess FTC limitation
$15.00
Under the look-through rules, the dividend from Red S.A. is put in the FTC basket
based on the income from which it was paid, in this case active business income. Such
income would be placed in the general category basket.
b. Can you offer Hannah any suggestions regarding how it might eliminate the residual
U.S. tax due on an 80u dividend from Red? Be specific in terms of the exact amounts
involved in any planning opportunities you identify.
Answer:
A dividend from Cedar A.G. (operating in a high-tax country) also will be placed in the
general category basket because of the look-through rules. This allows for crosscrediting by remitting a dividend from Cedar in the same year as the dividend from Red.
The foreign tax rate imposed on Cedars income is 50 percent. Each $1 of dividend
generates a deemed paid credit of $1 (1q/500q $500) and creates $2 of U.S. income.
The precredit U.S. tax on the $2 dividend is $0.70. The $1 deemed paid credit exceeds
the U.S. tax by $0.30. Hannah has a $15 excess FTC limitation. Therefore, Hannah
can receive a dividend of $50 from Cedar ($15/.30) and eliminate the excess FTC
limitation. The $50 dividend creates $100 of income ($50 + 78 gross-up of $50),
which generates a precredit U.S. tax of $35. The excess $15 FTC ($50 - $35) is
absorbed by the $15 excess FTC limitation.
59. (LO 5) {research} Identify the per se companies for which a check-the-box election
cannot be made for U.S. tax purposes in the countries listed below. Consult the Instructions to
Form 8832, which can be found on the Forms and Instructions site on the IRS website,
www.irs.gov.
a. Japan
24-25
Answer:
Kabushiki Kaisha
b. Germany
Answer:
Aktiengesellschaft
c. Netherlands
Answer:
Naamloze Vennootschap
d. United Kingdom
Answer:
Public Limited Company
e. Peoples Republic of China
Answer:
Gufen Youxian Gongsi
60. (LO 5) Eagle Inc., a U.S. corporation intends to create a limitada in Brazil in 2013 to
manufacture pitching machines. The company expects the operation to generate losses of
US$2,500,000 during its first three years of operations. Eagle would like the losses to flowthrough to its U.S. tax return and offset its U.S. profits.
a. {research} Can Eagle check-the-box and treat the limitada as a disregarded entity
(branch) for U.S. tax purposes? Consult the Instructions to Form 8832, which can be
found on the Forms and Instructions site on the IRS Web site, www.irs.gov.
Answer:
Yes. A limitada is eligible for a check-the-box election (a sociedad anonima is not).
b. Assume managements projections were accurate and Eagle deducted $75,000 of
branch losses on its U.S. tax return from 2013-2015. At 01/01/16, the fair market value
of the limitadas net assets exceeded Eagless tax basis in the assets by US$5 million.
What are the U.S. tax consequences of checking-the-box on Form 8832 and
converting the limitada to a corporation for U.S. tax purposes?
24-26
Answer:
Eagle will be treated as transferring the branch assets and liabilities to a foreign
corporation in return for stock. 367(a) will apply to the transaction. Gain will be
recognized on the transfer of tainted assets and intangibles, and the branch loss
recapture rules also will apply. Eagle will recognize gain of at least $5 million, the
lesser of the branch loss deduction or the appreciation of the assets transferred.
61. (LO 6) Identify whether the corporations described below are controlled foreign
corporations.
a. Shetland PLC, a UK corporation, has two classes of stock outstanding, 75 shares of
class AA stock and 25 shares of class A stock. Each class of stock has equal voting
power. Angus owns 35 shares of class AA stock and 20 shares of Class A stock. Angus
is a U.S. citizen who resides in England.
Answer:
Yes. Angus is a U.S. shareholder because he owns 10 percent-or-more of the total
combined voting power of Shetland PLC. Assuming each share of stock has the same
voting power:
35/75 Class AA stock = 46.6% 75/100 = 35% total voting power
20/25 Class A stock = 80% 25/100 = 20% total voting power
Combined voting power = 55%
Highlander PLC is a CFC because the U.S. shareholder (Angus) owns more than 50
percent of the total voting power or value of its stock. Angus would be required to
include in his income currently 55 percent of the corporations subpart F income.
b. Tony and Gina, both U.S. citizens, own 5% and 10%, respectively, of the voting stock
of DaVinci S.A., an Italian corporation. Tony and Gina are also equal partners in Roma
Corporation, an Italian corporation that owns 50% of the DaVinci stock.
Answer:
Yes. Tony and Gina are U.S. shareholders because they each meet the 10 percent of
voting power test:
Direct
Ownership
Tony
Gina
Total
Constructive
Ownership
5%
10%
25%
25%
Total
30%
35%
65%
24-27
Tony and Gina each own their pro rata share of the DaVinci stock owned by the Roma
Corporation under 958(b). DaVinci S.A. is a CFC because the U.S. shareholders
collectively own more than 50 percent of the value or voting power of its stock.
Tony includes 30% of DaVincis subpart F income in income currently, and Gina
includes 35% of DaVincis subpart F income.
c. Pierre, a U.S. citizen, owns 45 of the 100 shares outstanding in Vino S.A., a French
corporation. Pierres father, Pepe, owns 8 shares in Vino. Pepe also is a U.S. citizen.
The remaining 47 shares are owned by non-U.S. individuals.
Answer:
Yes. Pierre and Pepe meet the test to be U.S. shareholders:
Direct
Ownership
Pierre
Pepe
Constructive
Ownership
Total
8%
45%
53%
53%
45%
8%
Pierre is deemed to own the shares owned by his parent under the constructive
ownership rules of 958(b). Pepe is deemed to own the shares owned by his son under
the constructive ownership rules of 958(b). The corporation is a CFC because the
ownership of Pierre or Pepe is greater than 50 percent.
Pierre includes in his income currently 45 percent of Vinos subpart F income. Pepe
includes in his income currently 8 percent of Vinos subpart F income. (The constructive
ownership rules only apply to determine if the corporation is a CFC and a U.S. person
is a U.S. shareholder).
62. (LO 6) USCo owns 100% of the following corporations: Dutch N.V., Germany A.G.,
Australia PLC, Japan Corporation, and Brazil S.A. During the year, the following transactions
took place. Determine whether the above transactions result in subpart F income to USCo.
a. Germany A.G. owns an office building that it leases to unrelated persons. Germany
A.G. engaged an independent managing agent to manage and maintain the office
building and performs no activities with respect to the property.
Answer:
No. Rental income received from unrelated persons is not FPHC income if it is derived
in the active conduct of a trade or business. Rents are considered derived in the active
conduct of a trade or business if the CFC regularly performs active and substantial
management and operational functions during the lease period. This rental income
would not be FPHC income.
24-28
b. Dutch N.V. leased office machines to unrelated persons. Dutch N.V. performed only
incidental activities and incurred nominal expenses in leasing and servicing the
machines. Dutch N.V. is not engaged in the manufacture or production of the machines
and does not add substantial value to the machines.
Answer:
Yes. Dutch N.V. would not be engaged in an active trade or business because the CFC
did not add substantial value to the machines. The rental income would be foreign
personal holding company income.
c. Dutch N.V. purchased goods manufactured in France from an unrelated contract
manufacturer and sold them to Germany A.G. for consumption in Germany.
Answer:
Yes. The income from sales to German A.G. would be foreign base company sales
income because the goods were purchased from an unrelated person outside the CFCs
country of incorporation and sold to a related person for consumption outside the CFCs
country of incorporation.
d. Australia PLC purchased goods manufactured in Australia from an unrelated person
and sold them to Japan Corporation for use in Japan.
Answer:
No. The income from sales to Japan Corporation would not be foreign base company
sales income because the goods were manufactured in the CFCs country of
incorporation.
63. (LO 6) USCo manufactures and markets electrical components. USCo operates outside the
United States through a number of CFCs, each of which is organized in a different country.
These CFCs derived the following income for the current year. Determine the amount of
income that USCo must report as a deemed dividend under subpart F in each scenario.
a. F1 has gross income of $5 million, including $200,000 of foreign personal holding
company interest and $4.8 million of gross income from the sale of inventory that F1
manufactured at a factory located within its home country.
Answer:
The gross income from sale of inventory is not foreign base company sales income
because it was produced in the CFCs country of incorporation. The $200,000 of
interest income is FPHC income. Under the de minimis rule of 954(b)(3)(A), the
interest income is not treated as subpart F income if it is (1) less than $1 million and (2)
less than 5 percent of gross income. The interest is less than $1 million and is less than
24-29
5 percent of gross income ($200,000/$5,000,000 = 4%). The interest income is not

treated as subpart F income in this case.
b. F2 has gross income of $5 million, including $4 million of foreign personal holding
company interest and $1 million of gross income from the sale of inventory that F2
manufactured at a factory located within its home country.
Answer:
The interest income is foreign personal holding company income. The gross income
from sale of inventory is not foreign base company sales income because F2 produced
the inventory in its country of incorporation. Under the full inclusion rule of 954(b)(3)
(B), all gross income is subpart F income if gross subpart F income is more than 70
percent of total gross income. F2s subpart F income ($4 million) is 80 percent of total
gross income. Therefore, F2\s entire gross income ($5 million) is subpart F income.
COMPREHENSIVE PROBLEMS
64. Spartan Corporation manufactures quidgets at its plant in Sparta, Michigan. Spartan sells its
quidgets to customers in the United States, Canada, England, and Australia.
Spartan markets its products in Canada and England through branches in Toronto and London,
respectively. Title transfers in the United States on all sales to U.S. customers and abroad
(FOB: destination) on all sales to Canadian and English customers. Spartan reported total gross
income on U.S. sales of $15,000,000 and total gross income on Canadian and U.K. sales of
$5,000,000, split equally between the two countries. Spartan paid Canadian income taxes of
$600,000 on its branch profits in Canada and U.K. income taxes of $700,000 on its branch
profits in the U.K. Spartan financed its Canadian operations through a $10 million capital
contribution, which Spartan financed through a loan from Bank of America. During the current
year, Spartan paid $600,000 in interest on the loan.
Spartan sells its quidgets to Australian customers through its wholly-owned Australian
subsidiary. Title passes in the United States (FOB: shipping) on all sales to the subsidiary.
Spartan reported gross income of $3,000,000 on sales to its subsidiary during the year. The
subsidiary paid Spartan a dividend of $670,000 on December 31 (the withholding tax is 0%
under the U.S.-Australia treaty). Spartan was deemed to have paid Australian income taxes of
$330,000 on the income repatriated as a dividend.
a. Compute Spartans foreign source gross income and foreign tax (direct and
withholding) for the current year.
24-30
Answer:
Foreign source gross income on Canadian sales*
Foreign source gross income on U.K. sales*
Dividend from Australian subsidiary
78 gross-up for deemed paid income taxes
Foreign source gross income
Creditable foreign income taxes
Canadian income taxes
U.K. income taxes
Deemed paid credit on Australia dividend
Total creditable income taxes
$1,250,000
1,250,000
670,000
330,000
$3,500,000
600,000
700,000
330,000
$1,630,000
* Under 863(b), 50 percent of the gross income from sales is foreign source because
title to the goods passes outside the United States.
b. Assume 20% of the interest paid to Bank of America is allocated to the numerator of
Spartans FTC limitation calculation. Compute Spartan Corporations FTC limitation
using your calculation from Question A and any excess FTC or excess FTC limitation
(all of the foreign source income is put in the general category FTC basket).
Answer:
Gross income from U.S. sales
Gross income from Canada and U.K. sales
Gross income from Australia sales
Dividend from Australia subsidiary
78 gross-up on dividend from Australia subsidiary
Total gross income
Interest expense
Taxable income
x U.S. tax rate
Precredit U.S. tax
FTC limitation
Foreign source gross income (from A above)
Less: Apportioned interest expense (20%)
Foreign source taxable income
Taxable income
FTC limitation = $3,380,000 / $23,400,000 x $8,190,000
Creditable foreign income taxes
Excess foreign income tax credit
$15,000,000
5,000,000
3,000,000
670,000
330,000
$24,000,000
600,000
$23,400,000
x
0.35
$ 8,190,000
$3,500,000
120,000
$3,380,000
$23,400,000
$1,183,000
1,630,000
$ 447,000
24-31
Precredit U.S. income tax

Foreign tax credit
Net U.S. income tax
$8,190,000
1,183,000
$7,007,000
65. Windmill Corporation manufactures products in its plants in Iowa, Canada, Ireland, and
Australia. Windmill conducts its operations in Canada through a 50 percent-owned joint
venture, CanCo. CanCo is treated as a corporation for U.S. and Canadian tax purposes. An
unrelated Canadian investor owns the remaining 50 percent. Windmill conducts its operations
in Ireland through a wholly-owned subsidiary, IrishCo. IrishCo is a controlled foreign
corporation for U.S. tax purposes. Windmill conducts its operations in Australia through a
wholly-owned hybrid entity (KiwiCo) treated as a branch for U.S. tax purposes and a
corporation for Australian tax purposes. Windmill also owns a 5 percent interest in a Dutch
corporation (TulipCo).
During 2013 , Windmill reported the following foreign source income from its international
operations and investments.
CanCo
IrishCo
KiwiCo
Dividend income
Amount
Withholding tax
$45,000
2,250
$28,000
1,400
Interest income
Amount
Withholding tax
$30,000
0
Branch income
Taxable income
AUS income taxes
TulipCo
$20,000
3,000
$93,000
$31,000
Notes to the table

1. CanCo and KiwiCo derive all of their earnings from active business operations.
2. The dividend from CanCo carries with it a deemed paid credit (78 gross-up) of $30,000.
3. The dividend from IrishCo carries with it a deemed paid credit (78 gross-up) of $4,000.
a. Classify the income received by Windmilland any associated 78 gross-up into the
appropriate FTC baskets.
Answer:
Passive category basket
Interest income from CanCo
Dividend income from TulipCo
Total passive category gross income
$30,000
20,000
$50,000
24-32
Creditable passive category foreign income taxes

Withholding tax on TulipCo dividend
Total passive category creditable taxes
$3,000
General category basket
Dividend from CanCo*
78 gross up on dividend from CanCo
Dividend from IrishCo*
78 gross up on dividend from IrishCo
Branch income from KiwiCo
Total general category gross income
3,000
$45,000
30,000
28,000
4,000
93,000
$200,000
* The dividends from CanCo and IrishCo are general category income under the
look-through rules.
Creditable general category foreign income taxes
Withholding tax on CanCo dividend
Deemed paid credit on CanCo dividend
Withholding tax on IrishCo dividend
Deemed paid credit on IrishCo dividend
Australia income taxes
Total general category creditable taxes
$ 2,250
30,000
1,400
4,000
31,000
$68,650
b. Windmill has $1,250,000 of U.S. source gross income. Windmill also incurred SG&A
of $300,000 that is apportioned between U.S. and foreign source income based on the
gross income in each basket. Assume KiwiCos gross income is $93,000. Compute the
FTC limitation for each basket of foreign source income. The corporate tax rate is 35%.
Answer:
Gross income from U.S. sources
Total passive category gross income
Total general category gross income
Total gross income
SG&A expense
Taxable income
x U.S. tax rate
Precredit U.S. tax
$1,250,000
50,000
200,000
$1,500,000
300,000
$1,200,000
x
0.35
$ 420,000
Passive category FTC limitation

Foreign source passive category gross income
Less: Apportioned SG&A^
Foreign source passive category taxable income
$50,000
10,000
$40,000
24-33
^ $50,000 / $1,500,000 x $300,000

FTC limitation = $40,000 / $1,200,000 x $420,000
Creditable passive category foreign income taxes
Excess foreign income tax limitation
General category FTC limitation
Foreign source general category gross income
Less: Apportioned SG&A^
Foreign source general category taxable income
$14,000
3,000
$ 11,000
$200,000
40,000
$160,000
^ $200,000 / $1,500,000 x $300,000

FTC limitation = $160,000 / $1,200,000 x $420,000
Creditable general category foreign income taxes
Excess foreign income tax credit
Precredit U.S. income tax
Passive category foreign tax credit
General category foreign tax credit
Net U.S. income tax
$56,000
68,650
$ 12,650
$420,000
3,000
56,000
$361,000
66. Euro Corporation, a U.S. corporation, operates through a branch in Germany. During 2013
the branch reported taxable income of $1,000,000 and paid German income taxes of $300,000.
In addition, Shamrock received $50,000 of dividends from its 5% investment in the stock of
Maple Leaf Company, a Canadian corporation. The dividend was subject to a withholding tax
of $5,000. Euro reported U.S. taxable income from its manufacturing operations of $950,000.
Total taxable income was $2,000,000. Precredit U.S. taxes on the taxable income were
$680,000. Included in the computation of Euros taxable income were definitely allocable
expenses of $500,000, 50% of which were related to the German branch taxable income.
Complete pages 1 and 2 of Form 1118 for just the general category income reported by Euro.
You can use the fill-in form available on the IRS Web site, www.irs.gov.
Answer:
See attached filled-in Form 1118.
67. USCo, a U.S. corporation, has decided to set up a headquarters subsidiary in Europe.
Management has narrowed its location choice to either Spain, Ireland, or Switzerland. The
company has asked you to research some of the income tax implications of setting up a
corporation in these three countries. In particular, management wants to know what tax rate
will be imposed on corporate income earned in the country and the withholding rates applied to
interest, dividends, and royalty payments from the subsidiary to USCo.
24-34
To answer the tax rate question, consult KPMGs Corporate and Indirect Tax Survey 2011,
which you can access at
www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/corporate-andindirect-tax-rate-survey-2011.pdf. To answer the withholding tax questions, consult the treaties
between the United States and Spain, Ireland, and Switzerland, which you can access at
www.irs.gov (type in treaties as your search word).
Answer:
Tax rates
Spain
Ireland
Switzerland
30%
12.5%
8.5%
Withholding tax rates

Spain
Interest
Dividends
Royalties
10%
10%
8%
Ireland
Interest
Dividends
Royalties
0%
5%
0%
Switzerland
Interest
Dividends
Royalties
0%
5%
0%
24-35

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Chapter 24 - The U.S.

Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Income from concerts

U.S. source based on where the event took place

Dividend from French corporation

Foreign source based on residence of the payer

Interest on a U.S. corporation bond

U.S. source based on residence of the payer

Interest of $2,000 on a loan made to a

Foreign source based on residence of the payer

Gain of $80,000 on the sale of stock

Foreign source based on residence of the seller

Chapter 24 - The U.S. Taxation of Multinational Transactions

b. Spartan ships its eye shades F.O.B., place of shipment.

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Apportionment by gross sales

Chapter 24 - The U.S. Taxation of Multinational Transactions

Apportionment by gross income

Total U.S. source R&E ($1,500,000 + $3,375,000)

Withholding Tax Rate

Article 10, 2(b)

30% (U.S. statutory

Cash dividends of $2,000

Chapter 24 - The U.S. Taxation of Multinational Transactions

Identify Gamecos creditable foreign taxes.

Foreign tax ($20,000 x 45%)

b. Management plans to establish a second branch in Italia. Italia taxes corporate

Chapter 24 - The U.S. Taxation of Multinational Transactions

FTC limitation calculations

Chapter 24 - The U.S. Taxation of Multinational Transactions

Passive category basket income

Foreign tax credit allowed

Excess foreign tax credit

Chapter 24 - The U.S. Taxation of Multinational Transactions

Tappans E&P and foreign taxes are as follows:

Chapter 24 - The U.S. Taxation of Multinational Transactions

Excess FTC limitation

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

5 percent of gross income ($200,000/$5,000,000 = 4%). The interest income is not

Chapter 24 - The U.S. Taxation of Multinational Transactions

Chapter 24 - The U.S. Taxation of Multinational Transactions

Precredit U.S. income tax